When ETFs were first introduced, most only tracked the largest and broadest Indexes, but in recent years, they've grown in sophistication and popularity. Today you can buy ETFs that track just about any index or sector, and even some that try to emulate a strategy rather than following a specific group of investments.

An ETF (Exchange Traded Fund) trades on an exchange just like a stock, but rather than being a single security, ETFs hold a group of investments. They can be made up of bonds, precious metals, natural resources and many other asset types, ETFs are not limited to stocks. Don't let that flexibility fool you though, they are never a random hodge-podge of securities. An ETF always combines together a group of investments that have something in common and then tracks the combined performance. Most follow some type of Index, such as the S&P 500, and when you buy a share of an ETF, you get a small piece of every stock that the index tracks.

One thing that ETFs have in common with traditional mutual funds is that they pass their expenses on to you, the investor. There are two important tests that every ETF you buy should pass… First, minimize expenses by shopping for ETFs that have lower expense ratios than other ETFs tracking the same index. This is important because ETF expenses come right out of your returns. Second, make sure your ETF is accurately tracking its index, many can lag behind as a result of expenses or poor management. I'll explain how to perform both of these essential ETF tests below.

ETF vs Mutual Fund

The major difference between ETFs and traditional mutual funds is that you can buy ETFs throughout the day the same way you would buy a stock. Traditional funds can only be bought at the end of the trading day and everyone receives the same price, whereas ETFs are subject to the same daily price fluctuations that a normal stock would experience. One impact of this difference is that, since ETFs trade just like stocks, you will be charged transaction fees, but we'll discuss expense management below.

Why Would I Buy an ETF?

Most people that are new to investing are curious why there has been such an explosion in ETF popularity in recent years. Part of this is because of their flexibility, you can find a coinciding ETF for just about any type of stock, industry, geographic region or strategy that you'd like to try. You can usually own a share of the Wilshire 5000 or any other index that ETFs track for as little as $50. Can you imagine the cost if you tried to buy one share of every stock in the Wilshire 5000? Even if you could afford to buy a few shares of all 5,000 stocks, the transaction costs would make it a waste of time.

The fact that you can own a broad index when you buy into an ETF also means that you get diversification at a reasonable price, the cost of a single share. Your share will be spread over the same wide range of industries, categories and geographies as the person that owns 1,000 shares, you get the same diversification for 1/1,000th of the price.

ETFs have created an affordable way to have a professional grade portfolio that will outperform the majority of investors. A discouraging statistic for active investors is that only 20% of professional money managers beat the market returns, and this percentage is even lower for the average individual investor. ETF investors are guaranteed at least the market return for the indexes that their ETFs track so they can easily beat 80% of investors as long as they stick to the broader indexes and diversify.

Since an ETF only needs to track an Index, the fund manager will be doing a lot less buying and selling. This doesn't require a Harvard MBA and a team of analysts, the fund just rebalances occasionally to match the index that it tracks. This is why management and administrative expenses are much lower for ETFs than for the average mutual fund.

In addition to being expense efficient, ETFs are very tax efficient as well. Since trading creates the majority of tax liability, and ETFs trade infrequently (only when their index changes), they are much more tax efficient than traditional mutual funds.

You've probably heard that last one a hundred times, but here's a bit of tax info that is less well known and often misunderstood Many of the broader indexes, such as the S&P 500, track the largest and most successful companies in America. How do you get booted from S&P 500? If a company performs poorly and their market capitalization decreases (a fancy way to say the stock price drops) dramatically, they will be replaced. How does this create another ETF tax advantage? If a stock's price is dropping it is losing money. If the index (and your ETF) is only replacing stocks that are losing money, there is no capital gain to pass on to investors.

Finally, ETF investing is a low maintenance passive strategy that is easy to learn and implement in comparison to other investing strategies. What do I mean by low maintenance passive strategy? I mean you can choose several ETFs that track different broad indexes and then buy and hold and hold and hold. The simplicity of the strategy is a big perk, especially when you consider that experienced ETF investors beat most professional fund managers.

Drawbacks of an ETF Portfolio

There are many advantages to ETFs but they aren't suited to every investor, especially not if you're a dollar-cost averager. Dollar-cost averagers contribute small amounts of money on a regular basis, and this can be disastrous if you're buying ETFs because every buy and sell order creates a transaction fee. For example, if you contribute $100 per month to a particular ETF and each transaction costs $10, you are instantly losing 10% of your investment every month. Index Funds are a great alternative for dollar-cost averagers. Like ETFs, they track broad indexes but don't charge transaction fees when you contribute more money (more on Index Funds below).

Many ETFs don't do as well as the index that they track so be sure to chart and compare your ETFs to their peers and to their index before you buy (I'll explain how to easily do this below). The most common reason for performance lag is expenses, you can't expect your ETF to track the S&P 500 accurately if it has a 2% expense ratio. There can also be other factors such as poor management or inaccurate rebalancing, but the bottom line is avoid ETFs that don't accurately track their index.

Like stocks, ETFs are very easy to trade. They don't require any minimum investment, they can be traded any time that the market is open, and you can buy and sell as frequently as you like. This makes it tempting to try to time the market or chase returns, and also creates a lot of transaction fees that eat into your profits. ETFs are designed for buy-and-hold investors, they can be very expensive if you trade frequently.

There is a much wider range of ETFs available today, and many are very specialized. Specialization often means an ETF is tracking a much smaller basket of stocks so they tend to be more risky and volatile. If you invest primarily in these sector and specialty ETFs, you're giving up your greatest advantage as an ETF investor, diversification. Stick with the broader indexes, don't give up diversity to try to squeak out an extra 1 or 2% gain, chasing returns backfires every time.

One of the capital gains burdens that you're going to have to deal with on a regular basis as an ETF investor is dividends. They are taxable, and they are unavoidable if you're trading stocks and funds. Fortunately dividends do provide a benefit that offsets the tax liability that they create. Even though you'll have to pay taxes when a company passes you part of their profits in the form of dividends, they are also boosting your returns.

Index Funds: The ETF Alternative

I already pointed out that dollar-cost averaging is very expensive with ETFs, but don't worry, there's a great alternative that will still allow you to follow the exact same strategy. The alternative is Index Funds. Dollar-cost averagers can mix a few Index Funds into their ETF portfolio so that they can make small and frequent contributions to their portfolio without losing a lot of money in transaction fees. Even if you're trading through an online brokerage rather than dealing directly with a fund family, most Index Funds will still allow you to contribute money as often as you like without ever charging a fee.

A word of caution. When you begin comparing them to ETFs, you'll notice that Index Funds have higher expense ratios. Traditional funds and Index funds have to negotiate with online brokerage houses to get listed in investment databases. Rather than paying these fees, they pass the expense on to investors which increases the expense ratio of the fund. Typically, Index funds add between 0.15% and 0.35% to their expense ratio as a result of this expense. ETFs are treated differently than index funds, they aren't charged anything since they trade on the exchange like any other stock. These factors make it very hard for Index Funds to have expense ratios as low as ETFs.

This doesn't mean that all Index Funds have higher expense ratios, just that they tend to, unless they are very large. The point is, stick to the largest index funds that track the broadest indexes to minimize your expenses. An example of a great Index Fund that can compete with any ETF is Vanguard's S&P 500 fund (VFINX) with an expense ratio of 0.15%. Not many ETFs can top that, and they can't even come close if you factor in what a dollar-cost averager would pay in transaction fees when contributing frequently to an ETF.

Conclusion: So what are you waiting for?

ETF Investing is already getting big and the popularity will continue to grow because there is so much working in this strategy's favor. This is the most cost efficient and tax efficient strategy available, it's hard for other strategies to measure up, especially if you're investing in a taxable account. ETF Investing is also much easier to learn than many other strategies so it's perfect for beginners or anyone that doesn't want to spend hours per week researching investments and the market.

So what type of person masters this strategy quickly? Oddly, a person who places great value on their personal time, someone who doesn't want to become a professional investor or spend a lot of time managing their portfolio or studying stocks or the stock market. Who will have trouble mastering this strategy? If you're the type that can't resist trading frequently, trying to time the market, or chasing the “hot” sectors of the market, this strategy isn't for you, successful ETF Investors are Buy-and-Holders.

Her's a final encouraging word for the next time the market tests your resolve. Don't expect your ETF portfolio to always go up and always beat every broad index all the time. Sometimes the market will pop when conditions are extremely bullish and this can make it feel like your portfolio is lagging. Don't worry, you will shine during bearish, choppy, and volatile markets, your well planned blend of different assets across many categories maximizes returns while minimizing potential losses so you will ALWAYS win out in the long-term. Find high quality ETFs and a few Index Funds, follow the asset allocation and diversification guidelines you just learned, and then BUY AND HOLD AND HOLD AND HOLD.

Diversification and Asset Allocation with ETFs

I want some growth, but I also want to protect my nest egg. How do I optimize Risk Vs Return?

Experienced ETF Investors track their allocation and diversification mix because they know this is the difference between a good portfolio and a well-balanced professional grade portfolio. Why is this so important? If you master asset allocation and diversification, you can lower risk AND improve returns at the same time that's a pretty good combination.

There is no one asset allocation and diversification mix that is perfect for everyone, the goal is to find the investing sweet spot. This is the point at which you maximize risk vs return for your own personal risk tolerance and investing strategy. ETF investing provides a lot of flexibility, you can be an aggressive, conservative, or balanced ETF investor due to the broad array of ETFs available. Below are a few examples of different portfolio allocations that you can choose from.

Aggressive Asset Allocation

Profile: Aggressive ETF Investors are a long way from retirement and usually feel bullish about the market. They are looking for capital growth because their portfolios are usually still relatively small (by “relatively small” I mean not nearly large enough yet to support 30 years of retirement). They have a high risk tolerance and don't mind market volatility. They know they can weather any short-term market corrections or even recessions because they have a very long investing timeline (at least 15 years to retirement, usually more).

Balanced Asset Allocation

Profile: Balanced ETF Investors are mid-career and usually feel optimistic about the market but want to avoid extreme volatility. They are looking for capital appreciation but would also like to have a large chunk of their portfolio in the biggest and safest stocks that can dampen volatility and pay generous dividends. They tend to want some money in bonds for safe but modest returns and for the loss protection that they provide against stocks. While they still need growth, they also want protection against market volatility and losses so that they can retire in 10 to 15 years.

Conservative Asset Allocation

Profile: Conservative ETF Investors are retired, near retirement or feel very bearish towards stocks. They have very low risk tolerance and want to avoid volatility and losses. They are often focused on dividends and bond coupon payments since both provide current income during retirement. Many are withdrawing more than they contribute to their portfolios. Since this is a big part of their income they want a lot of protection against market volatility and losses because the portfolio needs to last for the rest of their retirement.

Because Index Investors have a variety of assets and stock types in their portfolio, some pieces will grow faster than others. This will throw the allocation and diversification off which means the portfolio is no longer optimized. To correct, Index Investors have to rebalance occasionally. Many index investors make it a habit to rebalance once per year to ensure that they stay in their investing sweet spot.